U.S. Stocks Dominate

Last quarter we discussed how the largest stocks in the Standard & Poor’s 500 Index are dominating stock market returns, helping drive S&P 500 returns versus stocks in the rest of the index and other major indices. Apple and Amazon continued to outperform in the third quarter with total returns of 27% and 14%, respectively. Microsoft stock was not as dominant, up 3.6% this quarter.

The S&P 500 index continued to dominate other major indices in the quarter, driven by strong technology and consumer discretionary stocks. The Russell 2000, an index of small U.S. stocks, generated a total return of 6.6% versus 8.9% for the S&P 500. Underperformance for the year-to-date on September 30, 2020, is a staggering 14.3%, with the S&P 500 total return at 5.6% versus -8.7% for the Russell 2000 Index.

The S&P 500 versus the MSCI All Country World ex-U.S. Index is also staggering, with the S&P 500 outperforming the international index by over 2% for the quarter and 10% year-to-date. The chart below illustrates the sharp outperformance of the S&P 500 Index versus the international index. Since 2009, the S&P 500 has run up over 400%, while the international indexhas increased less than 150%. The MSCI All Country World ex-U.S. Index is illustrated in the chart instead of the MSCI EAFE international index in the table. It differs from the MSCI EAFE primarily due to the inclusion of emerging market securities, while the EAFE index does not have this exposure.

International stocks enjoyed nice outperformance from 1997 through 2006. However, since that time we have seen U.S. stocks dominate. Several factors have been driving this outperformance. The value of the dollar can have a significant impact on stocks across the world. Additionally, the U.S. economy has enjoyed a stronger recovery since the financial crisis than international economies.

It is worth taking note of this dichotomy. From a valuation perspective, the 20-year average P/E ratio of the S&P 500 is currently 15.4x versus 13.5x for the international index. The current dividend yield for the S&P 500 index is 1.8% versus 3.0% for the international index. International stocks have historically paid higher dividends. However, from an overall valuation perspective, these differentials indicate a nice value opportunity with international stocks.

The stock market tends to revert to the mean. In other words, a sharp divergence like we’ve seen in U.S. versus international stocks is typically unsustainable. The differential in U.S. price-to-earnings ratio versus international is the largest it has been in over 20 years.

What could turn the tide and prompt international stocks to outperform U.S. stocks? Most likely we would need to see a significant drop in the U.S. dollar, evidence of a sustained economic recovery in developed international markets or significant headwinds for technology companies. This could be government regulation to raise taxes for these corporations, significant controls for user access or other unforeseen challenges that may be beyond their control.